Combining IS and LM Curves

Having found the IS and LM curves, we do the expected: we
place them together on the same graph. Only at the
intersection of the two curves are both the goods market and
the money market in equilibrium. At any other point at least
one of the markets is out of equilibrium. Consider point
a in the graph below. At point a the interest
rate is higher and expected income is lower than the
equilibrium levels. With the higher interest rates people
want to hold less money than they do at the equilibrium
level of interest, and at the lower expected income they
also want to hold less money than they do at the higher
equilibrium income. Thus there is more money in circulation
than people want to hold-- an excess supply of money. As a
result, people will try to get rid of surplus funds, or in
the jargon of economists, they will try to adjust their
portfolios. They can spend the money, or they can buy
financial assets, which will drive down interest rates and
increase spending.

Now consider what is happening in the goods market at
point a. At interest rate i people will spend
more than they expect to receive and thus actual income will
be greater than expected income. For income of Y to
be equilibrium income, interest rates must be higher.
Because actual spending will exceed expected spending,
expected income should rise and the economy should move
toward the IS curve. Some books call this situation a case
of excess demand in the goods market. This case is more
clear when the income-expenditure model is constructed in
terms of actual income and planned expenditures. Then at
point a planned expenditures will exceed actual
output and inventories will be decreasing.

The IS and LM curves look and act very much as supply and
demand curves do. Just as IS and LM can be interpreted as
lines of partial equilibrium, so can supply and demand
curves. The demand curve shows all the price-quantity points
at which buyers are in equilibrium, and the supply curve
shows all the price-quantity points at which sellers are in
equilibrium. Market equilibrium exists when both buyers and
sellers are in equilibrium, which only happens where the
curves intersect. One also can show by shifting the curves
how changes in factors held constant will affect the
equilibrium levels of the variables on the axis.

Examining the way the ISLM model is constructed reveals
that a change in fiscal policy alters only equations that
are used to build the IS curve, and changes in monetary
policy alters only equations used to build the LM curve. An
expansionary fiscal policy will shift the IS curve to the
right, increasing interest rates and income. An expansionary
monetary policy will shift the LM curve to the right,
increasing income but decreasing interest rates. The way in
which one shifts these curves is exactly the same as how one
shifts curves in the model of supply and demand.

ISLM reveals that financing can matter. It did not in the
simple income-expenditure model, which assumed that
financial markets imposed no limitations on the goods
markets. The differences in these models can be seen in the
graph below, where an increase in government spending shifts
the IS curve to the right. The simple income expenditure
model, in which there are no interest rates, would predict
that income would increase from Y1 to Y3. In
the ISLM model the shift in the IS curve increases the
interest rate, and this increase crowds out some
investment, at least partially offsetting the effects of
increased government spending. The steeper the LM curve, the
greater the crowding out that this model suggests.

Suppose this same increase in government spending were
financed not by borrowing from the public, but by printing
more money. In this case both the IS and LM curves would
shift to the right. As a result, interest rates would not
rise, investment would not be crowded out, and the increase
in income would be much greater.

We can skip over a technical section that looks at some
of the problems with ISLM and go next to a discussion of
Aggregate Supply and Demand,
the newest attempt to make macroeconomics look like supply
and demand.